The Time Value of Money

Bahrawar Said, PhD

Management Sciences (Finance)
Contents
 Understand the concept of Time Value of Money
 Be able to determine the Time Value of Money
Simple Interest
Compound Interest
Present Value
Future Value
Present Value of an Annuity
Future Value of an Annuity
3
Time value of money
Which would you prefer -- $10,000 today or $10,000 in 5 years?
Reason?

Obviously, $10,000 today.

Immediate receipt of $1000 gives opp to invest & earn interest.

You already recognize that there is

TIME VALUE TO MONEY!!
In a world in which all cash flows are certain, the rate of
interest can be used to
express the time value of money
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Now, Which should you prefer ?

$1,000 today or $2,000 ten years from today?

 To answer this question,

It is necessary to position time-adjusted cash flows at

periodic point in time so that a fair comparison can
be made.
 Time value of Money
 Time value of money is a concept that money available today is worth more
than the identical sum in the future due to its potential earning capacity.
 Key principle of finance is that provided money can earn interest, any amount
of money is worth more the sooner it is acquired.

 TVM is dependent not only on the time interval being considered but also the
rate of interest used in calculating current or future values.

 Based on this, we can use the time value of money concept to calculate how
much you need to invest or borrow now to meet a certain future goal
 Five components: Present value(PV), Future Value(FV), Periodic
Payment (PMT), Compounding, discounting.
6 Why TIME?
Why is TIME such an important element in your
decision?

TIME allows you the opportunity to postpone

consumption and earn INTEREST.
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 Simple Interest v/s Compound Interest
 Interest: A rate which is charged or paid for the use of money. An interest rate
is often expressed as an annual percentage of the principal.
 Changes in the nominal interest rate (Projected Inflation Rate + Real rate of
interest) often move with changes in the inflation rate, as lenders not only have
to be compensated for delaying their consumption, they also must be
compensated for the fact that a dollar will not buy as much a year from now as it
does today.
 Simple interest is interest paid (earned) only on the principal or original
amount borrowed (Lent).
 Compound interest is interest paid not only on the principal, but also on the
interest that has already been earned.
 Simple Interest:
Simple interest is money paid interest rate is the percent
only on the principal. charged or earned.

SI = P0(i)(n)
Number of time period that the
Principal is the amount of money money is borrowed or invested (in
borrowed or invested. years).

Compound Interest:
A  p1  r 
t

A is the final dollar value, P is the principal,

r is the rate of interest, t is the number of compounding periods per year.
 Rules to Remember
The following are simple rules that you should always use no
matter what type of TVM problem you are trying to solve:
1. Stop and think: Make sure you understand what the
problem is asking.
2. Draw a representative timeline and label the cash flows
and time periods appropriately.
3. Write out the complete formula using symbols first and
then substitute the actual numbers to solve.
4. Check your answers using a calculator.
 Example
 How much money will you have in 5 years if you invest $100 today at a
10% rate of return?
 Draw a timeline
i = 10% ?
$100

0 1 2 3 4 5

 Write out the formula using symbols:

FVt = P0 * (1+r)t or n OR FVt = CF0 * (1+r) t or n

Solve it… FV5 = CF1-5 * (1+0.10)5 …

Future Value (Compound/Terminal Value) with Single Amounts
 Is the value at some future time of a present amount of money, or a series of
payments, evaluated at a given interest rate.

 For any simple interest rate, the future value of an account at the end of n periods
is FVn = P0 + SI => P0 + P0(i)(n) P0 = 100, i = 8%, n = 10 =>
SI = P0(i)(n) => SI = 100(0.08)(10) = $80

 What is the Future Value (FV) of the deposit according to simple interest?
 Formula: FV = P0 + SI FV = P0 + P0(i)(n)
 To solve for the F.V at the end of 10 years (FV10), add interest earned on the
principal only to the original amount invested. Now,
 FV10 = $100 + [$100(0.08)(10)] = $180
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 Q?? PV= 190 i = 14% n = 15 Ans: ??
 Present Value
 Is the current value of a future amount of money, or a series of
payments, evaluated at a given interest rate.

 Sometimes we need to proceed in the opposite direction. That is, we know

the future value of a deposit at i percent for n years, but we don’t know the
principal originally invested.

 What is the Present Value (PV) of the previous problem w.r.t simple
interest?

 The Present Value is simply the $1,00 you originally deposited. That
is the value today! 03/24/2024
 FVn = P0[1 + (i )(n)]

 P0 = FVn /[1 + (i )(n)]

 Data: FV = 180 i = 8% n = 10
 PV = 180 / [1 + (0.08 )(10)]
 PV = 100

 QUESTION
 FV= 1100 i = 13% n = 15
 Ans: ??
14 Annuity
 Annuity is a series of payment occurring over a specified
number of periods.

 An annuity is a contractual financial product sold

by financial institutions that is designed to accept and
grow funds from an individual and then pay out a stream
of payments to the individual at a later point in time.

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15 Ordinary Annuity
 An ordinary annuity is that in which the payment occur at
the end of the each period over a specific time. Ordinary
annuity payments are made monthly, quarterly, semi-
annually or annually.

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16 Annuity due
 An annuity due is that in which the payment occur
at the beginning of the each period over a specific
time.

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 Ordinary Annuity Compounding
17 FVA = P(FVIFAi,n)= 1000(FVIFA5%,5)= 5526

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 Explanation:
 The bank sign an ordinary annuity compounding contract
of 5 year with a person paying him 5% interest on each
installment he made to bank.
 He sign a contract today and pay $1000 after first period
(month/year) as ordinary annuity, then second time $1000
till end of the 5th year.
 When he deposit last installment then after few days he
receives all his amount with 5% interest on each
installment which is 5526.
19 Future value annuity on compounding
 FVA = P (FVIFAi,n)

 FVA = (FVIFAi,n) (book)

 FVA = P([(1+i)n -1]/i) (manual)
 Investment = 1000, i = 8% and n =3.
 FVA = 1000(FVIFA8%,3)
= 1000(3.246)
 PVA = $3246

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 Present Value Ordinary Annuity Discounting
20 PVA = (PVIFAi,n) = (PVIFA5%,5) = 4329

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Explanation:
 This PVOA calculation tells you that receiving $952.38 today is
equivalent to receiving $1000 at the end of each of the next five years, if
the time value of money is 5% per year. If the 5% rate is a company's
required rate of return, this tells you that the company could pay up to
$178.30 for the two-year annuity.
 The $4329.48 is computed by using the PV of five payments. In other
words, receiving $1000 at the end of the first year has a present value of
$952.38 (for n = 1; i = 5%).
 Receiving the second $1000 at the end of the second year has a present
value of $907.03 (for n = 2; i = 5%). The total of those five present
values of all periods (A+B+C+D+E) equals $4329.48.
 The difference between the $5000 of total future payments and the
present value of $4329.48 is the interest our money earns while we wait
to receive the payments. This $670.52 difference is referred to as
interest, discount, or a company's return on its investment.
22 Present value annuity on Discounting
 PVA(present value of an annuity)

 PVA = (PVIFA ) (book)

i,n
 PVA = P[(1-[1/(1+i)n])/i] (manual)
 Investment = 1000, i = 8% and n =3.

 PVA = 1000(PVIFA )
8%,3
= 1000(2.577)
 PVA = $2577 03/24/2024
 Calculate the FV or PV of a series of uneven cash flows (i.e.,
compound or discount the Cash flows)
 Calculate the present value of $5000 to be received annually at the end of years 1 and 2, then $6000
annually at the end of year 3 and 4, and then finally $1000 in at the end of year 5. All cash flows will
be discounted at 5%.
$5000 $5000 $6000
$6000 $1000
0 1 2
3 4 5
 Formula: PV = FVn /[1 + (i )(n)] or PV = FV(PVIFi,n) => on page 704, Table II
 4760 PV = 5000 / [1 + (0.05 )(1)]
 4535 PV = 5000 / [1 + (0.05 )(2)]
 5184 PV = 6000 / [1 + (0.05 )(3)]
 4938 PV = 6000 /
[1 + (0.05 )(4)]
 784 PV = 1000 / [1 + (0.05 )(5)]
PV=$20201
24 Hints for Annuity valuation
The future value of an ordinary annuity can be
viewed as occurring at the end of the last cash flow
period, The present value of an ordinary annuity
can be viewed as occurring at the beginning of the
first cash flow period

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 Business Joke
 A businessman who needed millions of dollars to clinch an
important deal went to church to pray for the money.
 By chance he knelt next to a man who was praying for $100
to pay an urgent debt.
 The businessman took out his wallet and pressed $100 into
the other man’s hand.
 Overjoyed, the man got up and left the church.
 The businessman then closed his eyes and prayed, “And
now, Lord, that I have your undivided attention….”
You will never really understand
finance until you understand the
time value of money.

Thank you